Widely assumed to be a fabulously wealthy welfare state, Saudi Arabia is in fact an economic basket case waiting to
happen.

By Robin M. Mills<p>
Robin
M. Mills is head of consulting at Manaar Energy and author of The
Myth of the Oil Crisis and Capturing Carbon. Contact him at robin@oilcrisismyth.com or
via Twitter @robinenergy.
</p>

August 25, 2011

In 1935, an oilman visiting the Middle East reported back to his headquarters, "The future leaves them cold. They want money now." Although the temptation of overspending has repeatedly undermined oil-rich governments from Caracas to Tehran, Saudi Arabia avoided this trap over the last decade through fiscal discipline that has kept its expenditures below its swelling oil receipts.

But in a recent report striking for the candor of its unpalatable conclusions, Saudi investment bank Jadwa laid out the kingdom’s inexorable fiscal challenge: how to balance soaring government spending, rapidly rising domestic oil demand, and a world oil market that gives little room for further revenue increases. And that was before the recent economic turmoil knocked $20 per barrel off oil prices.

Saudi Arabia’s government spending, flat since the last oil boom in the 1970s, is now rising at 10 percent or more annually. And it will rise faster still: The House of Saud’s survival instinct in the wake of the initial Arab revolutions led King Abdullah to announce $130 billion of largesse in February and March. The resulting increases in government employment and salaries can be cut only at the cost of more discontent.

And that’s only what the kingdom is spending on its "counterrevolution" at home. Saudi Arabia will pay the lion’s share of the pledged $25 billion of Gulf Cooperation Council aid to Bahrain, Egypt, Jordan, and Oman. With Iraq, Syria, and Yemen likely flashpoints yet to come, the bill will only increase. Already, nearly a third of the Saudi budget goes toward defense, a proportion that could rise in the face of a perceived Iranian threat.

Meanwhile, fast-growing domestic demand poses a serious threat to oil-export revenues. The kingdom is one of the world’s least energy-efficient economies: With prices fixed at $3 per barrel for power generation and $0.60 per gallon of gasoline, Saudi Arabia needs 10 times more energy than the global average to generate a dollar of output. Subsidized natural gas, too, is in short supply, undermining an economic diversification drive focused on petrochemicals. As much as 1.2 million barrels per day (bpd) of oil are burned for electricity to meet summer air-conditioning demand, yet Jeddah, Saudi Arabia’s second-largest city, still suffers frequent power cuts. By around 2026, Jadwa projects that domestic consumption will be over 5 million bpd, exceeding exports, which will never again reach their 2005 peak.

This combination of higher spending and lower exports shortens Saudi Arabia’s time horizon. Usually considered, on shaky evidence, to be a "price moderate" within OPEC, the kingdom now requires $85 per barrel to balance its budget. That figure will rise to $320 by 2030, according to Jadwa. (Of course, just because the Saudis need a certain oil price to balance the budget does not mean they can get it. Higher prices today come at the inevitable cost of future revenues, as economic growth is reduced and consumers choose more efficient vehicles.)

Savings cushion the budget for now. But the experience of the last oil price cycle is likely to recur: $180 billion of assets in 1980 had become $176 billion of debt by the end of 2002, and despite the oil-price crash, Riyadh was able neither to cut spending nor to grow a viable non-petroleum economy. This time, Jadwa foresees that the Saudi Arabian Monetary Agency will be forced to draw down its $500 billion of foreign assets to the point where, by 2030, the country’s fiscal position will be under severe strain.

So far, the kingdom has been fortunate. This decade’s rapidly rising spending was enabled when Saudi Arabia’s main OPEC rivals, Venezuela, and Iran, left the field clear due to underinvestment in and mismanagement of their oil industries. Along with the war in Libya, this has allowed Saudi production to increase to its highest level in 30 years while prices have remained strong. But the good times will soon come to an end.

Oil prices have again, as in 2008, been allowed to get too high, too fast. The renewed economic downturn, combined with fears of overheating in China and other emerging markets, has only sharpened this challenge. Growing efficiency, demographics, and alternatives mean that OECD oil demand is probably in a slow, long-term decline, while non-OPEC supply is proving more robust than expected, with strong growth in Brazilian pre-salt oil and North American unconventional shale oil and oil sands.

And, for the first time since Oil Minister Ahmed Zaki Yamani did battle with the Iranians in the 1970s, Saudi Arabia faces a real challenger within OPEC. Even if Iraq’s ambitious plans are only half-realized, it will soak up more than half of global demand growth. Its vast, low-cost reserves make major production increases attractive even if they reduce prices. For its own reasons, Iran seeks to undermine Iraqi stability, but that would hardly be a palatable outcome for the Saudis either.

And that’s not all: Angola also has room for further growth; Muammar al-Qaddafi’s impending defeat may restore some of Libya’s production; and, with Hugo Chávez suffering from cancer, Venezuela’s oil policy may change after the 2012 election.

The Saudis’ dilemma is this: They hold nearly all OPEC’s spare capacity, their essential weapon for keeping the cartel in line. June’s "worst meeting ever" was actually a victory for Saudi Oil Minister Ali al-Naimi. Opposition by Iran, Venezuela, Libya, and others to a production hike left him free to increase output as far as he chose. Yet Saudi Aramco, the country’s monopoly state oil company, has few drill-ready development projects. Plans announced in 2008 to take Aramco’s capacity to 15 million bpd have not been implemented, and the only big project under way, the giant Manifa heavy oil field, with about 900,000 bpd, will mostly serve domestic needs.

So what should the Saudis do? Setting a credible target, say $70 per barrel, and defending it by creating new spare capacity would reduce long-term prices. By enduring some pain themselves and drawing down their vast savings, they would burn off high-cost competition, punish OPEC rivals that are ignoring quotas, and damage archenemy Iran. Yet they are understandably reluctant to spend billions of dollars on new fields at a time of wavering demand.

Ambitious plans for nuclear and solar power are no panacea. Saudi Arabia has no competitive advantage over other countries in alternative energy. If it succeeds in reducing oil use in transportation, other countries can too — so who will be buying Saudi oil?

The black hole in current policy discussions is improved energy efficiency. Raising domestic fuel prices would cut demand, allow development of higher-cost gas resources, and free up more oil for export. "Smart" subsidies or cash transfers could offset the price hikes for vulnerable groups.

A lower oil-price target would have to be combined with domestic spending restraint. The Saudi government cannot forever be the employer of last resort; reshaping education and labor policy to bring more Saudi citizens into the private sector would ease some social pressures. Between 2005 and 2009, 2.2 million private-sector jobs were created, but only 9 percent went to Saudi citizens.

Tinkering is not enough. Without radical reforms, Saudi leverage within OPEC will be increasingly constrained. The kingdom’s regional power will weaken, precisely at the time when it is attempting to step up its role. And in the long term, its economic and social model will come under intolerable strain.

Yet the crisis is still too far away, the lure of easy oil money too strong — and the policy changes required demand deft execution untypical of Saudi bureaucracy. As Machiavelli cautioned, "There is nothing more difficult to take in hand, more perilous to conduct, or more uncertain in its success, than to take the lead in the introduction of a new order of things."